We all know that we should save money for a rainy day. Pretty much every investing guru has told us for years that we should have safety net savings. However, four in ten Americans do not even have enough saved to cover an unexpected $400 expense, according to the Federal Reserve in May 2018.
We all need a rainy day fund to help us weather financial storms.
A safety net, or a rainy day fund, is a stash of money that can sustain you through any of life’s unplanned events that might otherwise derail your financial security and well-being. Having a pot of money saved means that you will not have the stress of living paycheck to paycheck. For instance, a safety net will allow you to cover an unexpected expense. Importantly, you should not need to resort to credit cards, high interest loans, or simply not being able to pay for a necessity at all.
How much should be in your safety net?
Unfortunately, this does not have an easy answer. One rule of thumb is to save $1000 as fast as possible so you have at least some emergency funds and then, after that, progressively save to your end goal. This end goal should be enough to get you by for at least 3 months, but preferably 6 months. If your employment is the type that you cannot easily replace, then you need even more. A select few may need up to 24 months or even more for their emergency fund.
The Federal Reserve, May 2018
Four in ten Americans do not even have enough saved to cover an unexpected $400 expense.
For example, if your living expenses are $3000 per month, you should have somewhere between $9000 and $18000 saved in your emergency fund. Unless you have a good reason, you do not want to save much more than that. Money that you do not need anytime soon is better invested in ways that are more risky than what I would recommend for your safety net. One reason some people may hold more than 6 months in their emergency fund is so they can sleep better at night. While this is a valid reason to hold more, saving too much in your emergency fund could stand in the way of saving for retirement or your other goals.
Where Should You Keep Your Safety Net?
There are people who keep their safety net money under a mattress and others who keep it in a savings or an investing account. There are a couple things that should guide your decision on how to store your safety net money.
First of all, we need to remember that there is always inflation (at least in the United States). What this means is that 1 dollar is worth less in goods and services this year than last year. In other words, if you keep your safety net in cash, every year it will have less buying power and, consequently, you will have to top it off at least every year. Inflation has recently been about 2% each year, so we would need to add 2% to the emergency fund each year. To make this problem less severe, we can try to seek some form of yield on our money to reduce the amount that needs to be replenished.
There are really two schools of thought on this issue. The first is the classical cash equivalent and short terms bonds solution and the second is the Betterment approach of using some more risky stocks in the mix.
My Recommendation: Cash Equivalents and Short Term Bond Funds
I think both of these routes are viable options but I recommend staying in cash and ultra short bond funds in order to protect your emergency fund from the volatile stock market. Volatility is generally good for returns but generally bad when discussing money that you might need at a moment’s notice.
This could look like a high yield savings account or money market account (like Marcus.com which currently has a 2.05% annual interest) or an exchange traded fund (ETFs) that holds bonds and/or notes.
There are several popular banks with good interest rates
Here is a list of some suggestions of banks which, as of this writing, have very competitive interest rates and would be good candidates for you emergency savings account:
|Capital One Money Market||2.00%|
|Sallie Mae Money Market||2.20%|
These banks are continuously competing with each other and rates will definitely change. Just stay away from banks like Chase and Wells Fargo which hardly pay anything at all.
Ultra Short Term Bond Funds Have Decent Yield Compared to Savings Accounts
Following is a list of several ETFs which you could use to keep your safety net relatively safe and secure. Unlike with bank accounts, you could potentially lose part of your initial investment if the market drops. However, this small risk of loss is compensated with a high chance of earning more interest. Also, the ETFs listed hold either short or ultra-short duration bonds and notes. The shorter the bond and the higher the credit quality, the less likely you will lose money in a downturn.
|ETF Ticker||Description||Yield (SEC 30 day)|
|SHV||iShares 1-12 Month Treasury Bills||2.15%|
|BIL||SPDR 1-3 Month Treasury Bills||1.96%|
|USFR||WisdomTree Floating Rate Treasuries||2.15%|
|FLRN||SPDR Investment Grade Floating Notes||2.57%|
|NEAR||iShares Short Maturity Bonds||2.63%|
|MINT||PIMCO Short Bond (Actively Traded)||2.54%|
|JPST||JPMorgan Ultra-Short Bond||2.71%|
|GBIL||Goldman Sachs US Treasury 0-1 Year||2.18%|
|VGSH||Vanguard US Treasury 1-3 Year||2.8%|
|SCHO||Schwab US Treasury 1-3 Year||2.8%|
High Yield Savings Vs. Exchange Traded Funds
While the yield of Sallie Mae appears to be very comparable to an ETF like SHV there is one advantage to the ETF SHV and one advantage to Sallie Mae. The advantage is that with a bank like Sallie Mae your principle is fully protected and insured. However, because all of these ETFs use high credit quality bonds (treasuries are as high credit quality as possible), the actual amount of risk in the ETF principal is really from the duration alone. Thus if you pick a very short duration ETF like USFR which has an effective 1 week duration, or BIL or GBIL which have several month durations, your actual risk is very low. ETFs like FLRN, NEAR, JPST, and MINT do not invest in US treasuries, meaning that they do have higher risk but they also have a higher reward due to the risk.
That said, the major benefit to using an ETF even when yields seem similar is the way that ETFs pay yield vs. how banks do. Banks pay out only the stated yield and then keep the rest of the earnings for themselves. In other words, even if the bank is earning 10 percent on your money by lending it for personal loans (like what Marcus does), you only get the percent promised stated. With ETFs the opposite is true. The investment manager only gets to keep the percent that is stated and you get to keep everything else earned. For a fund like SCHO that has a 0.06% expense ratio, you as the investor get almost all of the upside and the manager, in this case Schwab, only gets 0.06% each year.
What types of products should you avoid?
While you might think Certificates of Deposits (CDs) or individual bonds would be a good option, but they often lock your money up for a fixed period. Even though you might be able to sell your CD or bond on a secondary market, or access your CD early by paying a penalty, the difficulty to access makes it less than ideal for your emergency savings. You could also use a mutual fund instead of an ETF, but ETFs are generally cheaper to own and more tax efficient, making them the clearly better choice.
Another option is to use a money market fund for any of the ETFs that I will mention shortly. To clarify, a money market fund is not the same thing as a money market account, which is basically a high yield savings account. The reason I do not recommend a money market fund here is because they tend to be a worse vehicle than ETFs due to their higher fees and lower transparency for a very comparable product. In fact, a money market fund often has fees 5-10 times than a low cost ETF. If you choose to use a money market fund, consider Vanguard for its low fees and decent yields. Schwab is a good runner up. Just remember, higher yields generally correlate to either a riskier investment or a product with lower fees paid to the manager of the product.
A Possible Safety Net ETF Allocation
This is in no way scientific, but I would recommend buying several different ETFs to build out a portfolio. For example, you could buy 20% NEAR and 80% SHV. As a result, you would benefit from higher yield from the non-treasury notes in NEAR but still have a foundation of treasuries to reduce risk.
What I do is a little different but still very simple. I divide my safety net into thirds and have a third each in FLRN, USFR, and SCHO. For example, SCHO makes my yield higher without credit risk by taking on higher duration risk of 1-3 years. In the same vein, FLRN also provides higher yield with an extremely short duration due to its floating rate nature. However, FLRN has a higher credit risk because the notes are not treasuries. To round out my safety net, I use USFR for the last third. I use USFR because it is extremely safe with an effective duration of one week due to its floating rate. Additionally, USFR also has almost no credit risk because it is a US treasury.
The Second Approach to Safety Nets is More Risky and is Championed by the Company Betterment
Betterment has an idea that your emergency funds should seek yield with riskier investments. For instance, Betterment includes stocks and higher risk bonds in its model safety net portfolio. The reasoning is to fight inflation with yield and growth greater than inflation. The goal is that the safety net will never need to be topped off due to inflation.
While Betterment does have some clever mathematics and charts on its side, but I disagree with the approach. The time when you will most likely need your emergency money is when the market is collapsing. If that happens, stocks, and thus your safety net, will likely have lost much of their value. In fact, stocks have lost between 20-50% in prior market crashes. In short, a Betterment safety net portfolio with 40% stocks could conceivably lose 20% in value when you need it most.
I believe that Betterment moved to this model to compensate for the extremely low treasury yields several years ago. However, interest rates are on the rise and now it is very possible to obtain decent returns without taking on so much risk. You can read more about Betterment’s argument for its approach here, although you should take its sales pitch with a grain of salt and also know that nominal interest rates have more than doubled since Betterment published its research.
For me, the possibility of the stock portion of a Safety Net at Betterment dropping by 50% is simply too risky. That is to say, my emergency money should be available no matter what happens when the need arises.
My final thoughts
The most important thing is to start saving for your emergency fund. You can always figure out where to put your fund after you have several thousand dollars saved. Even though I love Betterment for general investment and retirement accounts, I cannot recommend its safety net approach. Importantly, the possibility of losing too much money in your safety net runs counter to the stability that you should have for emergency savings. In conclusion, better to simply fund a safety net with ETFs yielding around that of inflation and invest your other money more aggressively.
I recently wrote another post on why I recommend the Chase Sapphire Preferred credit card for travelers. Find my last post here.
Author: Kelton Johnson
Disclosures: I am long SHV, FLRN, USFR, and SCHO.